As we explained in our article Why You Need Life Insurance, a life insurance policy is for the living. Ultimately, the amount of insurance you need depends on your number of dependents and the number of bills they will be left with in the event of your untimely death.
Figuring out the dollar amount you need on your insurance policy sounds trickier than it actually is. Below we show you an easy way to calculate a ballpark estimate so you can have a starting point. The first thing to determine is what you need to have covered. Knowing this will protect your family and give them a solid foundation to build on as they move forward.
Do you have a business? Do you want to cover the estate taxes that they’ll need to pay? Do you still have a mortgage? Do you have any debt other than your mortgage? Unfortunately, they will also incur bills that will need to be paid to cover funeral expenses. Finally, if you do have debt beyond a mortgage, you will need a higher benefit amount on your life insurance policy to pay it off. Some people already have the above items covered and only need coverage against loss of future income. Everyone’s situation will be unique.
The Most Important Calculation
However, the most important calculation to determine is how much money your family will need each month to survive. It is important to calculate this accurately and not just guess. This number includes bills, debt payments, and even regular and retirement savings payments. Also, don’t forget to factor in potential future bills, such as schooling. Higher education can cost tens of thousands of dollars and some schools can even cost over $100,000 for a four-year degree. Once you know your monthly (including future) expenses, you can move on to the next step.
Here’s our quick and easy calculation: Let’s pretend that the bills your income covers are $3,000 a month. Multiply $3,000 times 12 to determine the yearly expenses you cover. In this case, your yearly total expenses add up to $36,000. Next, you need to calculate the number of years your family would have been counting on that income. For example, this might be until you would have retired. Let’s base our example on the scenario that you have 20 years until retirement. So, for the next 20 years, your family will need 20 x $36,000 to comfortably pay bills until being able to draw on Social Security and other retirement benefits. (They may be able to receive them earlier as survivor’s benefits, but we won’t calculate that into our simple calculation that we’re using here.) This number equals $720,000 in life insurance that you should purchase to keep your family comfortable in the event of your death.
Now, this is only a rough estimate as there are factors that could make that $720,000 go up or down. For example, your mortgage could be paid off during those 20 years or your child could choose a more expensive college than you planned for. Also, the rate of inflation increases the cost of living a slight bit every year. There are a plenty of factors that could move this number up or down but this is a great starting point.
So, while this isn’t exactly a high-level, scientific approach to determining the amount of life insurance you should buy, it’s definitely a sound estimate and much more accurate than a blind guess!
Finally, be sure to discuss these numbers with your spouse. No one likes to talk about the possibility of death, but if you’ve discussed your life insurance plan, and you’re both on the same page, the years beyond your passing will be easier for those you love.